Cashing In: How to Make Negative Interest Rates Work

There is a possibility that negative interest rates will work. In fact, there are several central banks that reduced policy interest rates to zero during the global financial crisis to boost growth. After that, exactly ten years later, interest rates remain low in most countries. While the global economy has been recovering, future recessions are inevitable. Severe recessions historically have required a 3 to 6 percentage point cut in policy rates. It should be noted that, if another crisis occurs, few countries would have that kind of space for monetary policy to respond.

As an alternative, there could be a solution to this problem. In this way, a recent study by the IMF’s technical staff has emerged, showing how central banks can configure a system that would make deeply negative interest rates a viable option.

It is necessary to say that the advantages and disadvantages of the system are specific to each country and should be carefully compared with other proposals, such as higher inflation targets, to increase the monetary policy space in a low interest environment. We consider these issues, and more, in our research.

World alternative

For their part, central banks have resorted to unconventional monetary policy measures. The euro area, Switzerland, Denmark, Sweden, and other economies have allowed interest rates to be slightly below zero, which has been possible because withdrawing cash in large quantities is inconvenient and costly. These policies have helped boost demand, but cannot fully compensate for the lost space of the policy when interest rates are very low.

One option to break the lower limit of zero would be to eliminate the cash. But that is not simple. Cash continues to play an important role in payments in many countries. To solve this problem, in the aforementioned study, in addition to previous research, a proposal was examined for central banks to make cash as expensive as bank deposits with negative interest rates, which makes deep-negative interest rates feasible while retaining the role of cash.

The proposal is for a central bank to divide the monetary base into two separate local currencies: cash and electronic money (electronic money). The electronic money would be issued only electronically and would pay the interest rate of the policy, and the cash would have an exchange rate (the conversion rate) against the electronic money. This conversion rate is key to the proposal.